Palisade Research - Fri, Jul 22, 2016

UGE International Ltd (TSXV:UGE) - Solar Power Is Getting UGE

pic of installing rooftop solar panels

In 1889, the Eiffel Tower was built to celebrate the centennial of the French Revolution, but it soon became a symbol of the Industrial Revolution. Over a century later, a New York-based company, UGE International, was commissioned to install several wind turbines that would provide electricity for the tower's first floor. Next time you sit in the 58 Tour Eiffel restaurant, raise a glass of champagne for another revolution that unfolds as we speak: the Renewable Energy Revolution.

pic of Paris' Eiffel Tower

Commercial Solar Industry

The market for companies selling and operating solar power expands as the cost of solar-generated power decreases for both residential and commercial customers. Fortune Magazine reports that some large-scale solar installations are already more cost-efficient than their natural-gas counterparts, even without government subsidies.

According to a 2015 study by investment bank Lazard, an subsidised utility-scale solar power costs $50 to $70 per megawatt-hour (or 5 to 7 cents a kilowatt hour), compared with $52 to $78 for the most efficient type of gas plant.

The fall in solar energy prices is a very positive fundamental driver for the whole solar power industry, but in our opinion, its commercial sub-industry stands to benefit the most.

The major reason for this is the fact that residential solar industry is highly concentrated. The top three players (SolarCity, Vivint, and Sunrun) control about 49% of the market. At the same time, the top three companies operating in the commercial space (SolarCity, SunPower, and Borrego Solar Systems) control only 26% of the market.

High fragmentation of the non-residential industry means there are more growth opportunities for small- and medium-sized firms, provided they can continue finding new clients.

Overall, GTM Research projects that by 2020 the US commercial space will have a value of US$3.8 billion (C$4.9 billion). In 2016, the sector should grow by at least 30% and will keep growing due to the extension of federal Investment Tax Credit and wider adoption.

These catalysts are external, companies working in the solar space can control them only partially, if at all. A successful solar energy-focused company should have these features:

  • A robust pipeline of new clients and projects;
  • Access to flexible and cheap financing to support growth and expansion;
  • Complimentary services to increase revenues and maintain client loyalty.

We will go through each of these points later and see how they apply to the company we focus on in this report. Before we get to that, however, let's take a high-level overview of a company that has, in our opinion, the potential to deliver double-digit gains for its investors.

The UGE Business Model

UGE International Ltd. (TSXV:UGE; OTCQB:UGEIF) provides renewable energy solutions to businesses. That means it just does not resell solar panels, but builds relationships with its clients by securing the financing, installing the equipment, and providing services to maintain these projects. From a customer's standpoint, it's a 'turnkey' solution, no work is necessary, and savings begin accreting right away. From the company's perspective, it can sell multiple value-added products and build long-term relationships with its clients, ensuring ongoing revenue.

A typical project looks like this:

UGE normally secures the site first, and then can approach a client detailing how much it can save by utilizing solar power. Typically, the client will sign an agreement to purchase power from the installed system for 20 years, which can be banked by UGE to one of its many financiers. The rate of return is built into the pricing presented to its clients along with UGE's margin. As we mentioned earlier, we run this return at 15%.

flow chart of contracting process

In the end, all parties win: the client gets access to cheap electricity, the finance company generates return on its capital; and UGE makes a profit from installing and maintaining an all-included energy solution. The following table illustrates this example:

table breakdown of a typical rooftop solar panel project

According to Deutsche Bank's 2015 Solar Outlook Report, most of the United States will reach grid parity in 2017. Grid parity means that electricity generated by a stand-alone solution like the ones UGE provides is as cheap as or cheaper than that available through conventional utilities. This fundamental development will convince more businesses to add solar projects to its electricity mix, a bonus for UGE as almost 40% of its revenue is from the United States.

Compared to clients in other countries, businesses in the United States and Canada may be the biggest winners when installing UGE solar projects. The company's US clients pay just $0.13 per kWh (compared to $0.16 in China or $0.18 in Philippines), yielding potential savings of 25%. While UGE's clients in Canada (majority Ontario) are compensated differently from using renewable sources for energy, the savings amount to almost the same as its southern neighbours. In China, this savings is only 15%.

UGE's focus on the US and Canadian market strategically relies on the favorable economics of solar power compared to traditional energy sources, plus the high savings potential its clients can realize from switching to UGE's solutions. Furthermore, UGE reiterates that its other geological divisions are also, 'heating up', namely the Philippines which currently account for 10% of the company's revenues.

UGE Pipeline

The company has an extensive pipeline of projects in all stages of completion. From April 2016 to March 2017, it is geared to deploy 131 'contracted' projects that will generate about US$3.8 million (C$4.9 million) in net cash flow to the company. As a reminder, the company's total revenue for the 12 months ending in March 2016 was US$6.5 million (C$8.5 million).

'Contracted' projects refer to ones where the client has already committed to a binding contract, as opposed to 'non-contracted' projects where the clients have signed a letter of intent or some other non-binding document. UGE has another 44 'non-contracted' projects in the pipeline, expected to bring in about US$4.1 million (C$5.3 million) if fulfilled. We would like to point out that 'non-contracted' projects almost always make it to construction, however, for the sake of prudency are discounted in our analysis.

Overall, from April of this year to March 2017, UGE should generate about US$8 million (C$10.2 million) in cash flow. We expect the numbers to be higher, but the company used conservative estimates in its projections. Specifically, it assumed a 15% margin where historically the margins have hovered around 20%.

The UGE Team

The company's performance will be driven by its team and at its head is Nick Blitterswyk, who founded Urban Green Energy (that's what UGE stands for) in 2008. The company started out as a wind-focused energy provider but as solar energy costs went down and the amount of market opportunities increased, UGE pivoted to focus on solar.

Another key player on UGE's team is Cameron Steinman, the company's Chief Strategy Officer, who brings over 15 years of international engineering experience and work on over 400 solar photovoltaic (PV) sites. Cameron was the President and Chief Engineer of Endura Energy, a company UGE acquired in February 2016.

The Endura acquisition was a major milestone for UGE. The purchase complemented UGE's existing expertise in sales, marketing, and finance with Endura's experience in engineering, procurement, and construction. A vertically-integrated company has better control of its margins, which was one of the key rationales of the acquisition. Since the commercial solar space is highly fragmented and ripe for M&A, we expect UGE to further consolidate as opportunities arise.

Funding Growth

UGE's current capital structure looks robust. The company has 39.3 million shares outstanding and about 800,000 options and warrants. Of these 39.3 million shares, 41.2% are held by the founders. Endura founders hold a further 22.6%.

With almost two-thirds of the company's outstanding shares in the hands of people inherently interested in growing UGE, we have no reason to be worried about moral hazard. The management has a lot of skin in the game.

UGE has around C$8 million in debt on the books. About half of this amount are loans to related parties: the company's directors, their spouses, and family members to the CEO. In short, people who are close to the management. This is reassuring as first, they have skin in the game much as the management does. Second, being associated with the company gives them long-term perspective. Third, and most importantly, they may be more flexible in negotiating or re-negotiating terms of their loans if the company needs to amend them. In contrast to this, a third-party lender might be more rigid in their attitude toward UGE as a lender.

We speculate that UGE will divest or spin-out its legacy wind assets as UGE's prospectus states a 'wind sales' on the horizon, which will alleviate C$3 million from the books. Thus, after the recent financing, UGE has C$2 million cash on the books with a very reasonable share and loan structure. The current treasury will be used towards working capital and G&A, and with that we expect UGE will finally be cash flow positive this year.

Valuation

Our analysis suggests that UGE is undervalued. We estimated its fair value based on comparable companies and a discounted cash flow model. Based on a peer median, UGE shares are worth C$0.81, while the discounted model yielded a per share value of C$0.72, giving us a blended one year target price of C$0.77.

However, we think there are several factors that can cause UGE to outperform its peers:

  • It is focused on a lucrative sub-sector in the solar industry. There is less concentration in the commercial solar space, which opens up more opportunities for smaller players;
  • It has proven its ability to attract high-profile clients. The Eiffel Tower contract is just one case, the company's case page is full of other examples;
  • UGE's global presence both in terms of operations and sources of funding makes it more resilient than if it would be if it operated and sourced funds primarily from North America;
  • Even as a small-cap company it has proven its ability to engage in successful M&A that are aimed at increasing the company's vertical integration. We believe that this strategy will be accretive in the long run.

For these reasons, we think assigning UGE a price range is more appropriate; this accomplished by using the 3rd quartile multiple instead of a median. For the peer group that UGE is working in, we forecast a share price of C$1.00, which bumps our blended target to C$0.86, or an upside potential of about 152%.

Risks

Even though about half of the company's debt is made to related parties, there is still risk that future performance may fluctuate and the company will find it difficult to pay off its loans.

Another source of uncertainty is UGE's ability to maintain its deal flow. Furthermore, even if UGE continues to grow its deal flow, a lot of its success will depend on third party contractors who are deployed to build out solar projects. If UGE is to scale, it will need to continue to hire top calibre talent.

Lastly, the company's relatively small size and illiquidity can be a concern for investors. Its volumes are not high with less 30,000 shares regularly changing hands.

Nevertheless, we believe that the upside potential outweighs the risks. With the current pipeline and even without any additional catalysts, UGE is well-positioned to generate shareholder value in the years ahead.

Palisade Global Investments Limited holds shares of UGE International. We receive either monetary or securities compensation for our services. We stand to benefit from any volume this write-up may generate. The information contained in such write-ups is not intended as individual investment advice and is not designed to meet your personal financial situation. Information contained in this report is obtained from sources we believe to be reliable, but its accuracy cannot be guaranteed. The opinions expressed in this report are those of Palisade Global Investments and are subject to change without notice. The information in this report may become outdated and there is no obligation to update any such information. Do your own due diligence.

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